ADVANCED TEST 1 QUESTIONS WITH
VERIFIED ANSWERS [GRADED A+]
WorldCom - ✔✔Overstated earnings by 11 billion from 1999-2002
-Capitalized network maintenance and other costs that should've been
charged to expense as incurred: overstated both reported earnings and
operating cash flow
-Understated allowance for doubtful accounts
What is meant by efficient securities markets - ✔✔"An efficient securities
market is one where the prices of securities traded on that market reflect
all information that is known"
• Rational utility maximizers
• Prices reflect all available information that is known
• No one investor can "beat' the market unless stocks are under/overpriced
by 'noise'
traders - no excess normal returns
©morren2025/2026.Year published 2026.
,• If information is incomplete, due to inside information, then stock prices
will not reflect
true value
• Stock price efficiency does not reflect true value - market is not
omniscient
• Unbiased and reacts quickly to new information - no serial correlation of
prices (random
walk)
• Quality and quantity is enhanced by prompt and full reporting
• Individuals differ in prior beliefs
• These differences average out, so market has superior information to
individuals
Accounting implications efficient securities markets - ✔✔1. Accounting
policies adopted by firms do not affect their security prices, as long as
these policies have no differential cash flow effects, particular policies used
are disclosed, and sufficient information is given so reader can convert
across different policies
2. Full disclosure goes hand and hand- disclose new info when benefits
exceed costs
©morren2025/2026.Year published 2026.
,3. Accounting bridges the gap in true value by providing more inside
information--accountants in competition with other information providers
4. Naive investors are protected by efficient markets. Naive investors can
rely on experts, and if enough informed investors trade, and naive investors
can trust markets are efficient
If enough informed investors understand the disclosed information, market
price is the same as if all investors are informed
How is stock market response to an earnings announcement measured? -
✔✔1. Measure a return window (one month or one day)
2. Measure abnormal returns in order to separate market-wide and firm-
specific factors
3. Measure unexpected earnings
4. Earnings response coefficient
Abnormal returns - ✔✔Actual returns less expected returns
Expected returns based on - ✔✔Market model such as CAPM, prior year's
returns, actual returns
©morren2025/2026.Year published 2026.
, Unexpected earnings - ✔✔Actual earnings - expected earnings
Expected earnings based on - ✔✔Prior earnings or analysts./management
forecasts
If response positive and statistically signifigant - ✔✔Causality if short
window: earnings cause a stock market response
Association if long window: earnings associated with a stock market
response
Earnings are relevant to investors
ERC implications: Growth, persistence, earnings quality, etc
Why does true net income not exist? - ✔✔1. Lack of objective state
probabilities
2. b. Equality of present values and market values under ideal conditions
suggests an indirect approach to true economic income—base the income
calculation on changes in market values rather than present values
©morren2025/2026.Year published 2026.
VERIFIED ANSWERS [GRADED A+]
WorldCom - ✔✔Overstated earnings by 11 billion from 1999-2002
-Capitalized network maintenance and other costs that should've been
charged to expense as incurred: overstated both reported earnings and
operating cash flow
-Understated allowance for doubtful accounts
What is meant by efficient securities markets - ✔✔"An efficient securities
market is one where the prices of securities traded on that market reflect
all information that is known"
• Rational utility maximizers
• Prices reflect all available information that is known
• No one investor can "beat' the market unless stocks are under/overpriced
by 'noise'
traders - no excess normal returns
©morren2025/2026.Year published 2026.
,• If information is incomplete, due to inside information, then stock prices
will not reflect
true value
• Stock price efficiency does not reflect true value - market is not
omniscient
• Unbiased and reacts quickly to new information - no serial correlation of
prices (random
walk)
• Quality and quantity is enhanced by prompt and full reporting
• Individuals differ in prior beliefs
• These differences average out, so market has superior information to
individuals
Accounting implications efficient securities markets - ✔✔1. Accounting
policies adopted by firms do not affect their security prices, as long as
these policies have no differential cash flow effects, particular policies used
are disclosed, and sufficient information is given so reader can convert
across different policies
2. Full disclosure goes hand and hand- disclose new info when benefits
exceed costs
©morren2025/2026.Year published 2026.
,3. Accounting bridges the gap in true value by providing more inside
information--accountants in competition with other information providers
4. Naive investors are protected by efficient markets. Naive investors can
rely on experts, and if enough informed investors trade, and naive investors
can trust markets are efficient
If enough informed investors understand the disclosed information, market
price is the same as if all investors are informed
How is stock market response to an earnings announcement measured? -
✔✔1. Measure a return window (one month or one day)
2. Measure abnormal returns in order to separate market-wide and firm-
specific factors
3. Measure unexpected earnings
4. Earnings response coefficient
Abnormal returns - ✔✔Actual returns less expected returns
Expected returns based on - ✔✔Market model such as CAPM, prior year's
returns, actual returns
©morren2025/2026.Year published 2026.
, Unexpected earnings - ✔✔Actual earnings - expected earnings
Expected earnings based on - ✔✔Prior earnings or analysts./management
forecasts
If response positive and statistically signifigant - ✔✔Causality if short
window: earnings cause a stock market response
Association if long window: earnings associated with a stock market
response
Earnings are relevant to investors
ERC implications: Growth, persistence, earnings quality, etc
Why does true net income not exist? - ✔✔1. Lack of objective state
probabilities
2. b. Equality of present values and market values under ideal conditions
suggests an indirect approach to true economic income—base the income
calculation on changes in market values rather than present values
©morren2025/2026.Year published 2026.
